CME looking to put its money on the Dow

February 04, 2010|By Greg Burns

With regulations looming that could weaken the financial might of U.S. exchanges, Chicago's trading industry is counting on what's commonly considered a sure thing.

From most angles, the exclusive right to list indexes such as the Dow Jones industrial average and Standard & Poor's 500 looks like the safest bet around. But even those slam-dunk money-makers could be vulnerable under proposals taking shape on Capitol Hill.

Chicago's CME Group Inc. is said to be bidding as much as $700 million for News Corp.'s Dow Jones index division, which reportedly generates licensing revenue of just $90 million annually.

The high price reflects monopoly power: Owning the indexes would enable the exchange to continue capturing practically all the volume while charging relatively high trading fees.

Similarly, the Chicago Board Options Exchange is banking on exclusive contracts such as its S&P 500 to boost results ahead of an expected initial public offering later this year. Most of its other core products face head-to-head competition on rival option marts.

It's little wonder the exchanges seek a measure of certainty. The hopefulness of a year ago has given way to a sinking realization that changes aimed at Wall Street big shots could hurt as much as help the marketplaces.

Some of their best customers could be cut back under proposals to limit proprietary trading at banks -- the so-called Volcker Rule -- and high-frequency trading at electronic market makers such as Chicago's GETCO LLC.

The Commodity Futures Trading Commission's planned energy-market position limits could reduce volume in the CME's Nymex unit, especially if they get stricter over time. Those limits may be extended to metal contracts as well.

A broader threat stems from a proposal to allow contracts on different futures exchanges to financially substitute for each other, known as "fungibility." The CME arguably has the most to lose if interchangeable versions of its contracts were listed at competitive marketplaces.

The index business, meantime, remains strong. Even after paying licensing and transaction fees, CME and CBOE are said to make a robust profit from their exclusively traded index products.

No wonder the Dow is so alluring.

"It's always great to own the license," said Michael Wong, an equity analyst at Morningstar Inc. The acquisition would enable CME to expand the product line and reduce its risk. A few years ago, the rival IntercontinentalExchange Inc. outbid CME for its Russell indexes.

CME leaders will field questions from Wall Street investors after unveiling the company's earnings Thursday.

One wild card: The ongoing effort to push more over-the-counter derivatives trading onto exchanges. Lawmakers and regulators want it, but it's still unclear to what extent Congress will force OTC products to openly trade and "clear," the back-office matching of buys and sells.

Over-the-counter versions of the leading exchange-traded indexes could provide new competition.

The issue is particularly sensitive for the options exchange as it proceeds with long-delayed plans to demutualize and, potentially, go public. CBOE officials never have disclosed the duration and terms of their index agreements, or broken down their profits by product line.

All that's known is that indexes produce roughly 20 percent of volume, and the exchange charges higher fees for those contracts than competitively traded options on equities or exchange-traded funds. If the exchange is excessively dependent on exclusive indexes for its earnings, it's not saying. CBOE officials declined to comment.

The political environment favors at least some movement of OTC products onto open platforms, noted John Damgard, president of the Futures Industry Association in Washington, D.C. That means more business for clearinghouses and, possibly, more competition.

"Maybe I'm an incredible optimist, but I look at all this stuff in the mix as more positive than negative," he said. "On balance, I think the sun's coming up."

No question, a little more sunshine could light up some dark corners of a high-stakes industry.